Chapter 11 Flashcards
When you see “sell” and “buy” think…
Supply and Demand
Describe The Market for Foreign Exchange
The market for foreign exchange brings together the demand and supply of foreign currency
The equilibrium price (b/t two currencies) is the exchange rate
Explain the impact of Currency Devaluations
Helps domestic suppliers (make more)
Helps foreign consumers (spend less) because they make exports less expensive in the foreign currency
Hurts domestic consumers (spend more)
Hurts foreign suppliers (make less) because they make imports more expensive in the domestic currency.
What does it mean when a Currency Appreciates?
It means
- demand is going up
- price is going up
- supply is going down
Why trade one currency for another?
- To invest in a foreign country, or
- To buy exports from a foreign country.
This increases demand for the foreign currency.
Describe the Impact of a Decrease in Pesos WRT golf in Mexico
It moves the demand curve to the right (i.e., increases)
Define the “Carry Trade”
A carry trade is a trading strategy that involves borrowing at a low-interest rate and investing in an asset that provides a higher rate of return.
Define Purchasing Power Parity
Means that exchange rates and/or prices adjust so that tradable goods cost the same everywhere.
If they didn’t, there would be a higher-valued use for the good, i.e., importers could make money by buying the good in one country and selling it in another. An act sometimes referred to as arbitrage.
Define The Economist’s Big Mac index
The Big Mac index is a way of measuring Purchasing Power Parity (PPP) between different countries. By converting the average national Big Mac prices to U.S. dollars, the same goods can be informally compared.
The index thus shows which currencies are over- or under-valued relative to the dollar
Describe the impact of a decrease in US interest rates
Lower interest rates lead to decreased investing
This is less attractive to investors, leading to a decrease in demand for USD
Causes a depreciation against foreign currency
What is the key to tracking currency changes?
Keep track of your frame of reference
Define a Bubble (Bubble-ology)
Bubble: prices that cannot be explained by normal economic forces
Bubble-ology: the study of prices not determined by the usual forces of demand and supply
Explain the self-fulfilling role of expectations WRT a price increase
- Buyers will accelerate their purchases to avoid it.
- Sellers will delay selling to take advantage of it.
- Both changes increase price.
- In this sense, expectations are self-fulfilling.
Define the 3 characteristics of bubbles
- Emerge when investors disagree about the importance of big economic events
- Involve very large increases in trading volume
- May continue even when many suspect a bubble. (It takes a “sufficient” number of skeptical investors to act simultaneously, which, so far, no one has figured out how to predict)
Define Arbitrage
Buying goods in one market and selling it in another when currencies are misaligned.
